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More Fed action: How would it work?

bernankeprinceton.JPG

Federal Reserve Board Chairman Ben Bernanke attracts a crowd as he walk across the Princeton University campus after giving a a public lecture over the weekend.

(Photo Credit/Martin Griff/AP Photo/The Times of Trenton)

By Neil Irwin
The debate over new Federal Reserve efforts to boost the economy has rapidly migrated from "whether" to "how."

Since Fed officials met last week and signaled they are open to new steps to try to strengthen the economy, chatter has flown around financial markets about the possibility of a major new infusion of cash, on the order of $1 trillion.

Some of this talk is a little premature: It is not a given that the Fed will take action at all at its the Nov. 2-3 meeting. If economic data come in surprisingly good over the coming weeks -- or inflation shows signs of rising -- the Fed may not intervene. But here is a guide to the range of technical and strategic questions that Fed leaders will need to resolve, should they choose to act, on how to ease monetary policy and stimulate growth. These are the questions that have already started to occupy both officials within the Fed and the outside analysts who scrutinize their every move.

More:
How much quantitative easing?
Shock-and-awe or dribs-and-drabs?
Treasuries or mortgage-backed securities?
Cut the interest rate on excess reserves?

How much quantitative easing?
This is the biggest question of them all. The strategy that Fed Chairman Ben Bernanke and company are most likely to pursue to try to strengthen economic growth and get inflation up closer to their 2 percent target is to buy vast quantities of bonds on the open market, essentially increasing the money supply.

That is called quantitative easing; Fed watchers refer to a new round of such easing "QE2," since it would follow earlier bond purchases announced during the financial crisis.

But how many hundreds of billions of dollars? In its previous efforts to prop up the economy, the Fed expanded the size of its balance sheet from $800 billion to about $2.3 trillion. That may have been a significant factor in ending the recession in June 2009. Still, the government was taking so many audacious steps to try to arrest the economy's free-fall that it's hard to know exactly how much of a role QE1 played.

The first round of quantitative easing probably had a greater impact on the economy than would any steps taken now, in part because the financial markets were dysfunctional at the time. Pumping hundreds of billions of dollars into the financial system improved conditions by jump-starting markets in which buyers and sellers weren't finding each other and liquidity had dried up.

The economy isn't collapsing anymore, and the financial markets are functioning somewhat normally, even though the economy is growing too slowly to bring down joblessness. That means that new quantitative easing would offer less bang for the buck: Each $100 billion of new easing would produce less incremental improvement in the economy than it did during the crisis.

Fed leaders will have to decide what to do with that insight. Does that mean they should go even bigger, undertaking $1 trillion or more in bond purchases because smaller numbers won't have enough impact? Or should they move more cautiously, given that the benefits are likely to be small?

Bernanke addressed this question in a speech last month, but had no definitive answers. "The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool," Bernanke said. "However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses."

Shock-and-awe or dribs-and-drabs?
A closely related question is how the Fed would announce new easing measures. In the earlier rounds of asset purchases, the Fed announced vast quantities of planned asset purchases all in a few, dramatic steps (such as a March 17, 2009, announcement that it would buy up to $1.25 trillion in mortgage backed securities, among other steps).

The shock-and-awe strategy has some clear benefits. Interest rates respond rapidly to the initial announcement, and then the Fed can take its time actually undertaking the purchases. It is a clear sign of commitment from the central bank that it is acting boldly, and by creating a boost in financial markets, the benefits for the economy can begin flowing the moment the announcement is made.

But St. Louis Fed President James Bullard has advocated having smaller purchases announced at each policy meeting, an approach that is gaining favor within the central bank.

For example, at the Nov. 2-3 Fed meeting, officials could announce, say, $200 billion in planned asset purchases. At the next meeting, Dec. 14, they could announce another round of similar asset purchases (if economic data has continued to disappoint), or no additional purchases if the economy seemed to be firming up.

With this strategy, the Fed would lose the immediate benefits of shocking financial markets with an announced wall of money. But they would gain the flexibility to respond to economic conditions as they evolve. That, in turn, may make it easier for some members of the Fed policymaking committee who are resistant to more easing to get on board; they would have greater assurance that the Fed balance sheet would only expand in a big way if economic conditions continue to go downhill.

Treasuries or mortgage-backed securities?
Further Fed easing would consist of buying assets. But what assets?

The two major options -- the assets that the Fed can purchase using its standard legal authority, as opposed to invoking emergency lending provisions -- are to buy U.S. Treasury bonds or housing-related debt issued by Fannie Mae and Freddie Mac. During the try-anything crisis response in 2009, the Fed did both. Here are the pros and cons of each.

Buying Treasury bonds is, in a sense, a purer exercise of the Fed's money-creation power. The purchases would lower the long-term rate on Treasury bonds, which are widely viewed as the "risk-free" rate across the economy. Other forms of debt, such as corporate lending, occur at some premium to the risk-free rate, so the Treasury bond purchases should pull down rates across the economy. Also, the Treasury bond market is enormous, so the Fed would have leeway to intervene without crowding out private buyers.

One major downside: If it buys Treasuries, the Fed could (and, if the past is a guide, would) be accused of "monetizing the debt," or printing money to fund large U.S. budget deficits. There is a risk that global investors would lose confidence in the independence of the Fed and not trust the central bank to step back from bond purchases in the future, which could cause a rise in interest rates and in expectations of inflation. Such a scenario would undermine the effectiveness of the new easing.

The second major option would be to buy mortgage-backed securities from Fannie and Freddie (and perhaps the companies' debt). One upside of this tack is that it would stimulate the troubled housing market by targeting mortgage rates directly. That said, mortgage rates have fallen dramatically over the last few months, with little apparent benefit to the housing market overall, so further declines might not make much difference for housing.

There are two major downsides to this strategy. First, it would put the Fed in the position of distorting capital allocation, favoring housing over other sectors. Treasuries would be more of a neutral step. Second, the market for mortgage securities has been slow to return to normal after the earlier Fed purchases -- $1.25 trillion ending in March -- crowded out private buyers. If the Fed gets back in, it may delay the return of private funding even further and thus be counterproductive.

Cut the interest rate on excess reserves?
Since summer, Fed officials have discussed cutting the rate they pay banks on reserves parked at the Fed as a tool to boost the economy. It works like this: For money they keep at the Fed beyond their regulatory minimums, banks are currently paid 0.25 percent interest. The Fed could cut that rate to close to zero, and then banks would have a bit more incentive to do something useful with that cash, such as lending it to clients.

But it would be no panacea. Banks are parking that money at the Fed because they want it to be very safe and readily available should they need it. So money that they no longer keep at the Fed banks would most likely pour into other ultra-safe, short-term investments, such as Treasury bills. That would not create much of an economic bounce, though at the margins it would reduce interest rates across the economy and have some mild benefit on growth.

That economic benefit, however, could prompt technical problems in the money markets caused by the decline of rates closer to zero. Still, the central bank would likely consider cutting the interest rate on excess reserves in conjunction with bond purchases.

By Neil  | September 28, 2010; 11:33 AM ET
Categories:  Federal Reserve  
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Comments

What world do these people live in and how does the president find such unqualified appointees? In the real world, which they apparently don't inhabit, tens of millions of people have lost their homes and jobs and the number of bankrupticies and layoffs continues to grow.

Whether or not our severe recession continues or ends will not be affected if the only interest rate the Fed sets, the overnight rate one bank charges another to buy reserves, goes up or down. The importance of the overnight interest rate is "common knowledge" among bureaucrats and pundits who never studied macroeconomics, and both totally wrong and incredibly naive. Who in the real world would think bankers are so stupid they would make loans for months and years because they can borrow money for 24 hours? Ask them - they laugh at the idea.

In the real world the responsibility and tools for achieving full employment belong exclusively to the Federal Reserve. The Fed is charged to increase the liquidity in banks at times like these when banks don't have enough money to lend just as it is charged to instantly reduce the banks' liquidity when there is so much spending that inflation will otherwise result. Neither activity requires changing the 24 hour rate between banks or, for that matter, any action by the congress or the president - although they being politicians always claim credit when the Federal Reserve is successful and blame others when it is not.

Our banks aren't loaning because they feel they need to hold the liquidity they now have as reserves. They need more liquidity so they can start lending and its the Fed's job to provide it.

Many tens of millions of Americans are unnecessarily hurting due to the Fed's inaction. Its disgraceful and The president is responsible in that he appoints the Fed's governors.

President Obama has, amazingly, across the board retained/promoted the economic-related decisionmakers appointed by his predecessor on the basis of politics rather than macroeconomic educations and real world experience. Appointing people such as the majority of current Fed governors is comparable to appointing people who studied to be chiropractors to the supreme court. If the president is to save his administration from the people's rightful anger he needs to accept some resignations and quickly find some macroeconomists with real world experience.

j398112@yahoo

Posted by: JohnLindauer1 | September 28, 2010 12:52 PM | Report abuse

QE without fiscal stimulus is likely to do nothing but stoke serious inflation. We can already see the regulators trying to cut off the spillover of the monetary inflation into commities by imposing position limits in the Dodd-Franks bill. Serious inflation is coming down the pike in about 6 to 9 months when the producer hedges on raw materials expire.

Posted by: leshoro | September 28, 2010 4:55 PM | Report abuse

Any reporting on what fiscal stimulus might occur next year?

This smacks of desperation by the Fed knowing that gridlock is coming to Washington. Nearly 320 billion dollars in tax cuts by the last two administration will expire on December 31st without action. The Republicans will also be revisiting the remaining stimulus spending for next year. That's almost 500 billion dollars in fiscal stimulus.

This move by the Fed is a sharp departure from classic Keynes. Asset buying is not likely to help anyone but the very wealthy who own most of the assets and feed into the kind of grass-roots resentment we're seeing in the current election.

Posted by: leshoro | September 28, 2010 5:02 PM | Report abuse

Who knew chicks dug central bankers? The girl in the photo at top looks smitten.

Posted by: Anonymous | September 29, 2010 3:53 PM | Report abuse

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